Sunday, December 14, 2008

Where did all the money go?

I've got a simple question about the Credit Crunch? Where did all the money go?

I've always thought of money as something that is "conserved" in the physics sense, like energy. Money in = money out + money stored. So when someone "loses" money it implies that someone else got it. If I run a company that loses money, what it means is that I'm getting less money in than I'm spending on staff and supplies. But the money hasn't disappeared, its just moved from my pockets to my suppliers (and their suppliers, and so on).

But the financial institutions seem to have had billions of dollars disappear into thin air. They got poorer, sometimes so poor that they went bust, but nobody seems to have become correspondingly richer.

I guess this has something to do with fractional reserve banking, which I know doesn't conserve money. Suppose I start with £1000 and put it in a bank. The bank shows a balance of £1000, but it doesn't just hang on to my money, it loans £500 of it to Joe Bloggs, who spends it on a new TV, and the person who sold the TV also puts the money in the bank. So now the bank has $1,500 on deposit even though our imaginary economy just started with £1,000. So what happens if Joe can't pay the money back?

14 comments:

Actually it loans out much more than $1000, rather $9000, on the assumption that most of the time these loans will get repaid. Now you can imagine what happens if not enough people pay back :) And you can also see of how sustainable the whole scheme is...

The answer is that money isn't conserved. Money isn't a tangible good but an abstract representation of value, and values change over time. There are a couple examples of this. Say for instance the simple question "How much cash is in the economy?". The answer turns out to be cash*liquidity (the amount a given dollar changes hands). So if I buy my Starbucks, and the bartista gets a new perm, and the hair stylist buys concert tickets... there is a lot of money in the system. If on the other hand I put cash under my bed then that latte money is effectively taken out of the system. The banks right now are holding onto cash or using it for buyouts, consumers are worried, employers are doing layoffs so liquidity is really low right now.

Also how much is a company worth? The answer is usually estimated at ('current stock price'+'value of dividends'*'outstanding shares'). At any one time though only a small fraction of a company's shares are changing hands though. So last year your a billion dollar company based on a stock price of 100$ and this year your a 100 mil company based on a 10 stock price. And that may be based on only 1% of your stock ever changing hands. So the company lost 900 million because 1 million dollars worth of stock trading hands. The same principle goes for anything that can be traded from national currencies, to iron ore.

The third point is to realize that an extremely large amount of the 'money' in the economy is in the derivatives market. These are basically sophisticated bets and contracts based on the expected price of other commodities. When a car company goes south there are always factories, machines etc that can be sold. Derivatives are not backed by anything so they are literally worthless if things don't go as expected.

This isn't to say that there are not winners in this economy. A few people saw this coming and short-sold the market and making lot of money on falling prices (they keep pretty quiet about it). Also because of the trade deficit and outsourcing laws a lot of dollars are parked in India, China, and Sandia Arabia.

I second the recommendation of "Money as Debt", although you should be aware that it's produced by monetary reform people, and so is not exactly unbiased. (Which is fine, as long as you're aware of it.)

Money is the measure of wealth, and this credit crisis and bear market housing market crash etc, is a loss of wealth. The loss of wealth is showing up in households going broke, losing their homes, investors share portfolios going down in value, and banks writing down the value of some of their loans.The banking system *issues* money, i.e. demand deposits and bank notes, and the stock of money is therefore at least somewhat elastic: if people want to hold wealth in the form of money, the banking system can issue it and hold other forms of wealth such as loans. If people do not want to hold money, they can hold bonds or loans or land or buildings instead, and the banking system sells assets to redeem the money issued. Metallic money is not issued but *minted* (i.e. manufactured) and in a closed economy, the stock of metallic money is pretty much fixed in the short run, and the banking system can't make anymore of the stuff.

Currency, in general, is conserved, but while currency is money, not all money is currency.

Money is whatever two actors are willing to use as part of a value exchange.

For example, most people think of their current bank balances as reserves of money, even though they are almost certainly aware that the bank doesn't literally just keep the currency equivalent in a vault.

Effectively what has happened over the housing run-up is a time-based transfer of money. Money was "cheap", i.e. getting loans to build houses was easy. Now, when money is more expensive, and rates are rising, foreclosures are increasing, and bank reserves need to be increased, what we are effectively doing is paying now for all that excess housing earlier.

Oh, and don't put much credence into the Money as Debt folks. Some of their facts are correct, but the solutions they infer would cast us back into the middle ages, being deeply inefficient etc.

Oh, and gold as a backer of currency isn't much different from government as a backer of currency - i.e. fiat currency - because there's nothing to stop the government from breaking the link again, so you're still dependent on government trust. And besides, that's just currency, not money.

Money is created by the fiat of the government: the central bank can increase the money supply by "printing money" (actually, printing doesn't come into it, but it's a useful shorthand) and buying securities with it, and it can also destroy money by selling its securities (and "burning" the money). In the long term, the money supply should expand at the same speed as the economy, so that prices would stay stable (on average). If the money supply expands faster than the economy, inflation (increase in the general price level) occurs, and if the money supply grows slower than the economy, deflation (decrease in general price level) happens – but this happens only in the medium to long term.

Money is also created by the fractional-reserve banking system, in which your checking account balance is (mostly) loaned out but you still have the right to withdraw it at will – thus, your checking account balance exists (almost) twice, as you have it and also the loanee has it. The minimum reserve requirement set by the government limits this kind of money multiplication, since banks cannot loan out everything, they are required to have some reserves.

Of course, the fractional reserve system works only so long as most people believe that they'll be able to withdraw their balance at will but do not actually do it. A "bank run" happens when people lose faith in a bank and everybody wants to withdraw all their balance RIGHT NOW – of course, since most of it is loaned out, the bank collapses. The other thing that can ruin a bank is if too many of its debtors default – the effect is not as dramatic as in a bank run, but it can trigger one.

(An even more dangerous than bank run is if the government decides to finance its expenditure by printing money. The effect is hyperinflation – prices rise very fast, and the public loses all faith in the currency. I believe Zimbabwe is currently experiencing hyperinflation, and one of the most famous cases in history happened in Germany in the 1930s.)

The global economy has been recently on the brink of massive bank runs, which ultimately go back to the unexpectedly many defaults of the subprime loaners. The bank runs have been mostly averted by the governments printing money and loaning it out to the suffering banks (which allows them to actually give money to those who want to withdraw more than usual) – since the money is mostly loaned to the banks, not gifted, this does not immediately create a hyperinflation threat.

Once a bank collapses, the money it has "duplicated" goes away, contracting the overall money supply. Some economists believe that this is one of the fundamental reasons for the US Great Depression in the early 1930s. Thus, governments try very hard nowadays to avoid widespread bank collapses (and where that doesn't work, the whole country is in trouble – have a look at Iceland).

In 1637, tulip bulbs were selling for more than 20 time what a skilled craftsman could earn in a year. The tulip market eventually collapsed, ruining the economy in the process. Where did the money go? Money is belief. When the belief goes away so does the money.

If you want to look at it in terms of conservarion, the conserved items are human input and human output. Money is just the measure whereby voting gets done on how the human input gets spent. It is self relative. Cutting the total amount of money in half or doubling it essentially changes nothing. This is why arbitrarily printing more money never works.

What really happens in a bubble is that people over vote certain items. These items then get produced excessively at the expense of other ones (this is nessesary due to the conservation of human input/output).

This is exacerbated by the fact that goods can be stored and consumed later, something that delays the feedback between the voting and the impact of that voting. There can be significant (incorrect) redistribution of human labour before the the reserves get drained and the impact is felt.

To make this even worse is that human input/output can not been instantaneously switched between items. A lot of potential human input ends up idling for awhile during the subsequent correction to human labour distribution. This further restricting the actual goods people want being produced.